A Bad Day At The Federal Reserve

There will be many more days ahead for the Fed, and many of them will have
plenty of good news. It is a mistake to trya and read too much into
one day's economic releases. With that said, here is my attempt to do exactly
that.

I tweeted the following real-time reactions (@inflation_guy) following the
CPI release this morning:

In Transp, the drag was almost all fuel. New/used Cars, maintenance, insurance,
airline fares, inter- and intracity transp all up.

What's amazing in the CPI today is how much it did with how little from
the main driver of housing. That uptick is yet to come.

...and, next month, headline will get upward pressure from the steep rise
in gasoline, which also dampens discretionary spending.

The primary takeaway from the CPI release is this: yes, core inflation surprised
a little bit on the high side. But it did so without the support of
the main factor that I think will push core inflation almost certainly higher
going forward: housing. Rents (both primary and OER) neither accelerated nor
decelerated this month from the prior year-on-year pace. And yet, there is
really no temporary factor that pushed inflation higher this month. It was
fairly broad-based. Apparel stood out on the month-to-month change perspective,
but here is the chart (source Bloomberg) on Apparel:

This month doesn't appear to me as too much of a true outlier. The underlying
dynamic there has simply changed.

So this month core inflation stayed at 1.9%; next month it is very likely
to return to 2.0% as we are dropping off the weak February change from last
year. And all of that, before the housing inflation hits the data.

Speaking of housing inflation, there is no sign yet of that abating. In today's
Existing Home Sales report, the year-on-year change in Median Existing Home
Sales Prices rose to 12.61%, another post-2005 record, and the highest real
price increase ever, outside of 2005. This is happening because the inventory
of new homes has dropped to almost a record low - really! Sure, the chart below
(source Bloomberg) ignores "shadow inventory," but it is starting to look more
like the inventory of new homes now.

Some of that is seasonal, but there's no doubt that lower inventories are
now helping the home pricing dynamic. And, as I've shown previously, the inventory of
existing homes actually has a nice relationship with shelter inflation 1-2
years later (Source: Enduring
Investments):

The current level of inventories translates into a 3.6% expected rise in CPI-Shelter
over the course of 2014. So you see, we're not only firing inflationary
rounds but we're also continuing to feed more ammunition into the gun for next
year. Our model of housing inflation projects Owners' Equivalent Rent no lower
than 3% by year-end 2013. And if that happens, there is no way that overall
core inflation is going to be at 2%.

Now, in addition to the bad news on prices and the news on home prices that
are probably seen at the Fed as a guarded positive (after all, it means the
mortgage crisis is essentially over as more borrowers will be 'above water'
again every month hereafter), there was also a mild surprise on the high side
from Initial Claims (362k versus 355k) and a bad miss on the Philly Fed index
for February. This latter was expected at +1.0 after -5.8 last month; instead
it dropped to -12.5. Philadelphia-area manufacturers have reported softening
business conditions in three of the last four months, suggesting that December's
pop to +4.6 was the outlier. Now, there were similar one-month dips in August
of 2011 and June of 2012, so we'll have to see if it is sustained...but it
is consistent with the report out of Wal-Mart and the worsening of business
conditions in Europe.

Higher prices (and more coming, on the headline side, as retail gasoline prices
have now risen in 35 consecutive days) and lower business activity. This is
exactly the opposite of what the Fed wants. It has been a bad day at
the Fed.

However, it is exactly what traditional monetarism expects: accommodative
monetary policy leads to higher prices (check), and has no effect on real activity
in the absence of money illusion (check). So score one point for Friedman today.

And so, what else would you expect after such a day? Bond yields are declining,
inflation breakevens are narrowing, and industrial commodities (metals and
energy) are sliding. As with so much else these days, that makes no sense,
unless you just don't know what's going on. When we encounter these bouts with
irrationality (or, more fairly, thick-headedness), the market can be frustrating
for a long time - and the ultimate denouement can sometimes be jarring.
As I said earlier in this post: buckle up!

Michael Ashton is Managing Principal at Enduring
Investments LLC, a specialty consulting and investment management boutique
that offers focused inflation-market expertise. He may be contacted through
that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist,
and salesman during a 20-year Wall Street career that included tours of duty
at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation
derivatives markets and is widely viewed as a premier subject matter expert
on inflation products and inflation trading. While at Barclays, he traded
the first interbank U.S. CPI swaps. He was primarily responsible for the creation
of the CPI Futures contract that the Chicago Mercantile Exchange listed in
February 2004 and was the lead market maker for that contract. Mr. Ashton
has written extensively about the use of inflation-indexed products for hedging
real exposures, including papers and book chapters on "Inflation and Commodities," "The
Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven
Investment For Individuals." He frequently speaks in front of professional
and retail audiences, both large and small. He runs the Inflation-Indexed
Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes
for client distribution and more recently for wider public dissemination.
Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University
in 1990 and was awarded his CFA charter in 2001.